(FORTUNE Magazine) – As Newt Gingrich and his cohorts in the House race to implement their Contract with America, their ambitious promise to cut taxes and spending while balancing the budget by the year 2002 seems to be unraveling. Congress's Joint Committee on Taxation calculates that the tax cuts proffered in the Contract--among them, a 50% capital gains exclusion, indexing of depreciation for inflation, and a $500-per-child tax credit--would reduce federal revenue by some $700 billion over ten years. Though Republicans have promised to offset those losses by trimming at least as much from spending, squeezing out the requisite savings is clearly proving far more difficult than they thought.

What to do? Since the mood of the country seems more inclined toward deficit reduction than tax reduction, one option might be to sacrifice tax cuts. But that flies in the face of the House Republicans' oft-stated vow to honor their pledge to take action on every item in the Contract.

Happily, there is a way out of this dilemma: Stop tinkering with small tax changes and embrace sweeping tax reform. Just in time, Robert E. Hall and Alvin Rabushka of Stanford University's Hoover Institution have weighed in with a road map that shows precisely how to do that, a new edition of their book The Flat Tax (Hoover Institution Press, $14.95).

These longtime advocates of flattening the tax code propose setting a single 19% tax rate on all individual and business income. Businesses would be taxed on gross revenue minus the following: cash wages; salaries and pensions paid; purchases of goods, services. and materials; and all capital equipment, structures, and land. Individuals would be taxed on their wages, salaries, and pensions received less a large personal allowance-and pay no tax whatsoever on interest, dividends, or capital gains. Under the Hall-Rabushka scheme, a family of four would have to earn $25,500 a year before it paid any income tax.

At first glance, it may appear impossible that such a tax system could raise the same $740 billion that the federal government expects to reap from individual and corporate income taxes in 1995. A flat tax also initially seems to be an enormous giveaway to the rich, who now pay rates as high as 39.6% on all income except capital gains, which are taxed at a maximum of 28%.

In fact, the numbers in The Flat Tax do add up. Nor is the plan quite the giveaway to the wealthy that it appears. The reason is simple: in return for gaining the ability to expense capital investment, companies would lose the ability to deduct the cost of fringe benefits and interest, as well as a long list of other business tax incentives. On the individual side, taxpayers would lose the ability to deduct mortgage interest, charitable contributions, and state and local taxes, among other things. And keep in mind that while interest and capital gains would not be taxable for individuals, they would be taxable at the business level.

The bottom line on this festival of tax base expansion and simplification is that it would roughly triple current federal revenues from taxing businesses, while halving individual income tax revenues. Since business income largely accrues to the wealthy, the effect of the Hall-Rabushka plan is to raise the actual amount of taxes paid by rich people even as their tax rate falls. By removing current disincentives to save, work, and invest, moreover, a flat tax should generate faster economic growth--and thus an even larger tax base. Professor Dale Jorgenson of Harvard recently predicted that if something like the Hall-Rabushka plan were enacted, it would lead to an immediate $2 trillion increase in national wealth.

Given that delightful prospect, it makes little sense for Republicans to keep struggling to cut capital gains taxes and improve depreciation allowances--and by doing so jeopardize their commitment to deficit reduction--when with no revenue loss, they can abolish the capital gains tax altogether and provide immediate expensing of capital equipment simply by adopting the Hall-Rabushka plan.

Okay. It's not quite that simple. Slaughtering such political sacred cows as the mortgage deduction won't be easy. But no other reform solution, including the consumed-income tax plan being pushed by Senators Sam Nunn and Pete Domenici, is so appealingly simple or does more to foster the savings and investment the U.S. so desperately needs.

House Majority Leader Dick Armey is preparing to introduce the Hall-Rabushka plan in Congress, and hearings are scheduled for later this year. So look for The Flat Tax to show up soon on Newt's required reading list for Republicans. Democrats might want to read it too.

Bruce Bartlett is a senior fellow with the National Center for Policy Analysis in Washington, D.C.